What you should know before buying an annuity
Your grandfather warned you about pensions, but what if a pension is right for you? Find out whether you should buy an annuity here.
What is a pension?
The short answer is: An annuity is an insurance contract that provides the owner or annuitant (and their spouse, if a survivor annuity is chosen) with a guaranteed income for life.
The long answer is: An annuity is an insurance contract – not an investment – issued by a financial services company or insurance company. It pays out invested funds, often earned interest and sometimes growth, at some point in the future in the form of a fixed-interest stream. Many people purchase annuities to provide guaranteed income for a predetermined period of time, usually for life.
This is the main advantage of pensions; Pensions help reduce or even eliminate income insecurity for those who need it, usually pensioners.
Imagine a trapeze artist in training with a safety net underneath him as he practices. They are dexterous but have a net underneath them for extra protection. Pension plans are like a safety net and can protect you from exceeding your income – a fear that many older people live with today.
However, annuities are long-term strategies, not short-term strategies, and they can be part of a long-term financial plan, not necessarily the entire plan.
What types of pensions are there?
There are different types of annuities: immediate and deferred annuities, fixed and variable annuities, and of course hybrid annuities. There are always hybrids.
Immediate annuities are funded by lump sum payments from an inheritance, lawsuit, or lottery win, in return for immediate cash flow that lasts over a predetermined period of time or a lifetime. Deferred annuities are typically intended for older investors who seek tax-deferred growth and guaranteed income by a specific date in the future and are valid for a predetermined period or for life.
Fixed annuities have fixed terms, such as: B. fixed interest rates and payment periods. Variable annuities offer payouts of varying amounts based on the performance of an underlying investment portfolio designed by the insurance company. Payouts depend on contributions during accumulation, returns and fees.
Indexed annuities are a mix of fixed and variable annuities and are the more complex type of annuity. Indexed annuities offer a guaranteed minimum interest rate combined with an interest rate tied to a market index. For example, an underlying index would be the S&P 500. An annuity indexed to the S&P 500 does not reflect the S&P 500 but is influenced by it.
What phases are there in retirement?
An annuity consists of two phases: the accumulation phase and the payout phase.
During the accumulation phase, the annuitant makes payments that can be divided among various investment options. This payment may be a lump sum payment, a recurring payment, or contributions over a period of time
During the payout phase, the annuitant receives payments from capital, income and possible profits. The payout period can last for a predetermined period of time, such as 15, 20 or 30 years, or for the life of the annuitant (or his or her spouse if a survivor benefit is elected).
What are the risks of purchasing variable and indexed annuities?
Variable and fixed annuities are designed for long-term commitment. Due to the underlying index, they also carry the risk of market fluctuations, although losses can be mitigated with the right annuity insurance. Finally, early withdrawals often result in early withdrawal penalties and taxes.
What is a pension rider?
Ads for cars often show the price of the base model. Car buyers then add features to their car orders, increasing the net cost. Car buyers can add as many features as they want, and the more features they add, the higher their costs rise.
This is the case with pensions and pension riders. Annuitants can choose a “base plan” of fixed, variable, immediate or deferred annuity and add additional benefits or additional features to meet their needs or concerns.
The two known contributors include a living benefit contributor and a death benefit contributor. A living beneficiary helps retirees during their lifetime. Payouts are adjusted for inflation and based on the age of the annuitant or his or her spouse. A death benefit is triggered when a pension recipient dies and the money from their pension goes to a beneficiary to pay funeral costs or to fund a donation or charity.
Other factors, as noted above, may include maximum loss protection for indexed annuities, accelerated terminal illness benefits, a cost of living factor tied to inflation, or the Consumer Price Index (CPI). There are also impaired risks, commuter payouts and care needs.
How much do pensions cost?
Fees for an annuity may include, but are not limited to:
- Administrative fees
- Prepayment penalty
- Additional rider
- Brokerage fees
As the car analogy explains, the more complex an annuity contract is, the more expensive the annuity is.
A broker who sells an annuity receives a commission or a flat fee. Commissions are paid based on the dollar amount invested in an annuity contract. The fee depends on the additional benefits of the annuity contract and can be between 0% and 10%.
For example, if you buy a bottle of wine at a restaurant, the cost and the amount you spend will increase depending on how much you tip (e.g. a commission). When you go to a liquor store, your costs only increase based on how many bottles of wine you purchase (e.g. the wine bottles you purchase).
When should you think about buying an annuity?
Most people purchase an annuity primarily because they want guaranteed, predictable income. So the main reason you might be thinking about buying an annuity is because you’re at a point where you want guaranteed, predictable income.
A pension also offers the possibility of unlimited tax deferral. Both company-sponsored retirement plans, such as 401(k)s, and individual retirement accounts (IRAs) have contribution limits and are available only to those who have earned income each year. So if you have either exhausted both of these retirement savings options or are not currently working and still want to save money with a tax-deferred vehicle, a pension is right for you. A bonus is that there are no withdrawal requirements; You can keep your pension for as long as you want.
Other reasons to consider purchasing an annuity include that the stock market is too volatile for your risk tolerance, you want premium protection or a more specific return, or you want to know exactly how much interest you will earn. Finally, annuities can compensate for your inability to purchase life insurance or provide you with long-term care coverage if you don’t want to pay for it out of pocket.
What are the risks of buying an annuity?
Like everything, a pension is not without risk. Below are some risks you should consider before purchasing an annuity.
1. Opportunity cost
Opportunity cost is the loss of potential growth you might gain by investing your money elsewhere, probably in the stock market.
It’s important to remember that an annuity is not an investment and annuitants are not necessarily looking for growth. Additionally, opportunity costs only apply to those who have a higher risk tolerance. Conservative investors or those who would otherwise prefer to sit in cash are not affected by this risk if they can sleep better at night.
2. Purchasing power risk
Purchasing power risk is an inherent risk in annuities because the return provided by an annuity may not keep up with inflation, making it more difficult to purchase as much or more tomorrow as you do today. Purchasing power risk also exists for those who hold their money in cash, interest-bearing accounts, and low-yield money market funds, although many people still invest their money in these investments.
3. Liquidity risk
Liquidity risk is the risk that you will not be able to easily access the money in your pension, which is also inherent in many fixed income products and alternative assets, including real estate.
However, many annuity issuers allow retirees to withdraw up to a certain percentage of their cash each year without penalty. This early exit is usually limited to 10%. However, money withdrawn early from a pension may still be taxed.
4. Risk of withdrawal
Surrender risk involves paying surrender charges on funds withdrawn early from an annuity. The redemption risk includes early withdrawal penalties (which may be waived for withdrawals of up to 10%) and taxes.
5. Market risk
As with investing in stocks, mutual funds, and ETFs, market or investment risk is the burden associated with variable and indexed annuities because a portion of the annuity reflects all or part of the stock market. Market or investment risks can be mitigated by protective factors that transfer market risks to the issuer.
6. Credit risk
As with bonds and other fixed-interest products, credit risk is the risk that the pension issuer will become insolvent, thereby making it impossible for the issuer to make the agreed payments to the pension recipients. If you are considering purchasing an annuity, check the issuer’s creditworthiness with rating agencies such as AM Best, Standard & Poor’s, Moody’s and Fitch and only purchase highly rated annuities.
We begin and end this section by noting that annuities are not without risk. However, nothing is without risk. The stock market is not without risk. Keeping your money exclusively in cash is not without risk.
Each of us must educate ourselves about the risks of all the instruments we consider as part of our overall financial plan and balance the risks we can tolerate with the returns we seek.
Why do people buy annuities?
People buy an annuity primarily because they want regular payments for a specific period or a guaranteed income from a specific date and for the rest of their lives. Ideally, this retirement income supplements income from Social Security, retirement account investments, and other sources of income. However, it can sometimes be a solution when other sources of income are not sufficient.
Another popular reason for purchasing annuities is tax-deferred growth. This is a crucial advantage for people who have already exhausted their contributions or do not have access to other pension insurance. Tax-deferred growth is an efficient way to grow retirement assets because taxes on retirement interest are not due until the money is withdrawn. This allows pension recipients to benefit more from compound interest over time.
Ultimately, many annuitants purchase their annuity for a death benefit. This means you can leave money to your heirs, whether you want to leave a legacy or care for your loved ones after your death. Money that remains with the beneficiaries of an annuity is often not inherited through an estate. Beneficiaries can receive the entire account value, principal less withdrawals, or the account value plus accrued interest as part of a guaranteed death benefit.
What are the myths about pensions?
Many myths about pensions often prevent people from considering a pension, even if it would be an excellent solution for them. To make the best decisions, it’s important to separate fact from fiction.
1. Pensions are bad investments
Pensions are not investments; they are insurance contracts. Comparing bonds with stocks and stock market performance is like comparing apples with oranges.
Pension insurance is just another tool to potentially increase your overall retirement savings and ideally nothing more. Remember that with the exception of Social Security (which many believe won’t last) and pensions (which many don’t have), pensions are the only product that guarantees an income stream that you can’t outlive.
2. Pensions are risky
Let’s be honest. There is no 100% risk-free route to retirement planning. Investing in the stock market involves risks. There are risks in not investing in the stock market. Even CDs and bonds carry inherent, although different, risks. Annuities are just one tool in a toolbox to improve your financial security in retirement, and they are just a few of the tools you can use to generate income for life.
However, it is possible to reduce the risks of purchasing an annuity – the full trust and creditworthiness of the insurance company ensures annuity payments. So you should choose an insurance company with a good credit rating from Standard & Poor or Moody.
This may sound complicated, but insurance companies purchase insurance from other companies. This helps reduce the insurance company’s risks and ensures that a company does not carry more risk than it can handle if something catastrophic happens. Insurance purchased from other insurance companies is called “reinsurance.” Therefore, you should also make sure that the insurance company you choose has reinsurance for your additional protection.
Finally, it might be helpful to know that each state covers at least $250,000 in cash value of pension benefits, including net cash return and net cash withdrawal values
3. If I have an IRA, I don’t need a pension
Annuities, like retirement accounts, offer tax-deferred growth. A common objection to buying an annuity, therefore, is that unless an investor is already maximizing their contributions to company-sponsored and individual retirement accounts, it is a waste of time to think about buying them.
Although there are benefits to maximizing annual contributions to these accounts, most people do not have enough saved and invested in their IRAs to meet their needs, and they should not be automatically excluded from the unique benefits of retirement savings. Annuities provide features that are missing from standard retirement accounts, even if annual contributions to standard retirement accounts are maximum.
Annuities can offer a guaranteed interest rate and guarantee that you and your spouse will receive a guaranteed income for life. Annuities can provide some or all of the above death benefits for you and your heirs.
Finally, Annuities are the only product that guarantees an income stream that you cannot outlive.
4. If I die, the insurance company keeps all my money
It’s true that with some annuities, if you die, the insurance company keeps your money. This way they can cover the payouts for other pension recipients – this is how many insurance products work. However, this generally only applies to life or immediate annuities. If this affects you and your family, do not purchase a lifetime or immediate annuity. There are other options.
It is also true that most pension insurance policies are designed to provide beneficiaries with a payout in the event of death. To ensure your heirs receive such a benefit, purchase an annuity that provides beneficiary benefits.
Another consideration is purchasing a variable annuity. Variable annuities often allow annuitants to withdraw money early in exchange for a surrender fee, typically 10% like 401(k)s, and taxes similar to 401(k)s.
5. Pensions are expensive
Some stocks are expensive (Hello Tesla! Hello Berkshire Hathaway!), and some annuities are expensive, such as many variable annuities. Some annuities are not expensive, for example many fixed annuities. The more expensive pensions have their advantages. Research what features you need in an annuity and compare these to the amount you are willing to pay for an annuity.
One way to keep your costs down is to only consider fixed annuities. Most fixed annuities have no maintenance or annual fees. Additionally, limit the number of drivers you purchase. Adding riders increases the overall cost of your pension and may trigger a maintenance or annual fee. Likewise, the commissions for complex annuities are higher because the seller has to do more work.
While withdrawal fees can be expensive, there are exceptions for some withdrawals, such as disability or long-term health needs. Withdrawals typically do not incur surrender charges to cover nursing home expenses if the annuitant is diagnosed with a terminal illness or must meet IRS-imposed minimum distributions (RMDs). It’s also good to know that redemption fees typically decrease over time.
With all that said, it’s important to remember that you’re paying:
- Guaranteed lifetime income for you and/or your spouse
- A way to earn income after retirement
- Fundamental protection
- Death benefit
- Tax-deferred growth
6. I should not consider a pension until near or after retirement
Look, we’ve now reported on pensions in several podcasts and that’s why we wrote this article We believe everyone should be open to all financial planning tools available to them. Because of the way annuities have been created and sold in the past, too many people discount annuities without doing their research first.
But today’s pensions are not your grandparents’ pensions. It’s also likely that your grandparents had both pensions and Social Security to support them in retirement. It is likely that unfortunately you do not have a pension. An annuity can replace a pension.
However, immediate annuities tend to be popular with retirees, and deferred annuities are more commonly used for saving before retirement. However, evaluate your wishes and expectations and speak to a financial planner or insurance agent about the type and structure of an annuity that is best for you.
Finally, certain annuities can help protect your future income from market volatility, and some can protect you from inflation. As you age, market volatility and inflation increase, and you may value this retirement protection.
7. It’s stupid to get a pension when interest rates are low
Warren Buffett once said, “Stop predicting the direction of the stock market, the economy, or the election.” We will add, “Stop predicting where interest rates will go and what the Fed will do.”
Nobody knows what the Fed will do tomorrow, not even the Fed. Plus, the Fed is playing a short game; When planning for retirement, you play the long-term game.
Professional pension tip: The free look period
Finally, it might be helpful to know that most annuities offer a 10- to 30-day “free look” period. Most insurance companies or financial services companies offer prospective retirees a period of time immediately after signing a contract in which they can cancel the contract and get their money back.
So try an annuity and return it if you don’t like it.
All in all, annuities are just another tool you can add to your financial planning. We hope we have given you enough information about annuities to pique your interest in how they can help you and your loved ones.
More tools to prepare for retirement: